Mnuchin Warns of Audits in Blue States as Tax Showdown Continues(1)

By Laura Davison

Treasury Secretary Steven Mnuchin threatened to target tax audits at residents of states such as California and New York that are seeking ways to restructure their state income taxes to lessen the blow of the new tax law.

High-tax states have been looking for ways to creatively get around the tax law that caps at $10,000 the amount of state and local taxes their residents can deduct. California has proposed to allow residents to make a donation to the state to satisfy their income tax liabilities and claim the charitable contribution as a credit to reduce their federal tax bill. New York is considering swapping the personal income tax for a business payroll tax that employers could deduct.

“I can assure you we will audit the real estate taxes issue,” Mnuchin said Jan. 12 at the Economic Club of Washington, responding to a question about states’ plans to create workarounds.

The comment highlights what is one of the most politically sensitive points in the tax overhaul—Democrats say the GOP targeted blue states, which tend to have higher taxes, to fund their tax overhaul. Republicans argue that the deduction subsidizes high-tax state residents.

The Internal Revenue Service and Treasury Department didn’t respond to a request for comment on how the audits would work and what authority the agency has to disallow deductions.

Shots Fired

Mnuchin’s comments furthered the debate that has been playing out between the Republican-led Congress and Democratic governors and state legislatures since the new tax act (Pub. L. No. 115-97) passed Dec. 22, with each side trying to outsmart the other to get the final word.

“People are angry about what they interpret as Republicans in Congress using the tax law to hammer their political opponents,” said Daniel Hemel, an assistant professor of law at the University of Chicago. “If you’re a blue state, this is political gravy. You are saving money for residents and protecting the state’s ability to collect revenue. Why wouldn’t you do this?”

States might not do this if they’re not sure it will hold up to IRS scrutiny, said Jared Walczak, a senior policy analyst at the Tax Foundation.

“The IRS operates on the concept of substance over form,” he told Bloomberg Tax. “What a state or local government calls it or how they frame it matter much less that what it actually is.”

Walczak says existing IRS guidance, regulations, and case law make it unlikely that the California charitable contribution plan will work out. The New York plan is tougher to challenge legally, he said, but does present logistical difficulties in implementing the system.

But for states where significant revenue is at stake—which could be tens of billions dollars for residents in California or New York—the cost may be worth the potential savings, Hemel said.

Audit Considerations

“Maybe the IRS drags people through audit, but it’s still a heads we win, tails we tie situation,” he said. “If IRS shuts this down, people wouldn’t be worse off than they are now.”

Mnuchin’s warning of audits raises a practical consideration, said Donald Williamson, the executive director of American University’s Kogod Tax Center. The IRS doesn’t have the manpower to audit every New York and California taxpayer, he said.

The number of audits the IRS conducts annually has been steadily decreasing, falling nearly 34 percent from 2009 to 2015 as the agency’s budget has declined, according to IRS data. Additionally, audits take several years to select and complete, so it’s unclear how many auditors the agency will have in the future.

“Right now they’re auditing 2015 and won’t be done for a couple months,” Williamson said. “2018 audits won’t occur until 2020 or 2021. That’s a long way out.”